4 Steps To Building A Profitable Portfolio

By Chris Gallant AAA |

In today's financial marketplace, a well-maintained portfolio is vital to any investor's success. As
an individual investor, you need to know how to determine an asset allocation that best conforms
to your personal investment goals and strategies. In other words, your portfolio should meet your
future needs for capital and give you peace of mind. Investors can construct portfolios aligned to
their goals and investment strategies by following a systematic approach. Here we go over some
essential steps for taking such an approach.
Step 1: Determining the Appropriate Asset Allocation for You
Ascertaining your individual financial situation and investment goals is the first task in
constructing a portfolio. Important items to consider are age, how much time you have to grow
your investments, as well as amount of capital to invest and future capital needs. A single college
graduate just beginning his or her career and a 55-year-old married person expecting to help pay
for a child's college education and plans to retire soon will have very different investment
strategies.
A second factor to take into account is your personality and risk tolerance. Are you the kind of
person who is willing to risk some money for the possibility of greater returns? Everyone would
like to reap high returns year after year, but if you are unable to sleep at night when your
investments take a short-term drop, chances are the high returns from those kinds of assets are
not worth the stress.
As you can see, clarifying your current situation and your future needs for capital, as well as
your risk tolerance, will determine how your investments should be allocated among different
asset classes. The possibility of greater returns comes at the expense of greater risk of losses (a
principle known as the risk/return tradeoff) - you don't want to eliminate risk so much as
optimize it for your unique condition and style. For example, the young person who won't have
to depend on his or her investments for income can afford to take greater risks in the quest for
high returns. On the other hand, the person nearing retirement needs to focus on protecting his or
her assets and drawing income from these assets in a tax-efficient manner.
Conservative Vs. Aggressive Investors
Generally, the more risk you can bear, the more aggressive your portfolio will be, devoting a
larger portion to equities and less to bonds and other fixed-income securities. Conversely, the
less risk that's appropriate, the more conservative your portfolio will be. Here are two examples:
one suitable for a conservative investor and another for the moderately aggressive investor.

The main goal of a conservative portfolio is to protect its value. The allocation shown above
would yield current income from the bonds, and would also provide some long-term capital
growth potential from the investment in high-quality equities.

A moderately aggressive portfolio satisfies an average risk tolerance, attracting those willing to
accept more risk in their portfolios in order to achieve a balance of capital growth and income.
Step 2: Achieving the Portfolio Designed in Step 1
Once you've determined the right asset allocation, you simply need to divide your capital
between the appropriate asset classes. On a basic level, this is not difficult: equities are equities,
and bonds are bonds.
But you can further break down the different asset classes into subclasses, which also have
different risks and potential returns. For example, an investor might divide the equity portion
between different sectors and market caps, and between domestic and foreign stock. The bond
portion might be allocated between those that are short term and long term, government versus
corporate debt and so forth.
There are several ways you can go about choosing the assets and securities to fulfill your asset
allocation strategy (remember to analyze the quality and potential of each investment you buy not all bonds and stocks are the same):

Stock Picking - Choose stocks that satisfy the level of risk you want to carry in the equity
portion of your portfolio - sector, market cap and stock type are factors to consider.
Analyze the companies using stock screeners to shortlist potential picks, than carry out
more in-depth analyses on each potential purchase to determine its opportunities and risks
going forward. This is the most work-intensive means of adding securities to your
portfolio, and requires you to regularly monitor price changes in your holdings and stay
current on company and industry news.

Bond Picking - When choosing bonds, there are several factors to consider including the
coupon, maturity, the bond type and rating, as well as the general interest rate
environment.

Mutual Funds - Mutual funds are available for a wide range of asset classes and allow
you to hold stocks and bonds that are professionally researched and picked by fund
managers. Of course, fund managers charge a fee for their services, which will detract
from your returns. Index funds present another choice; they tend to have lower fees
because they mirror an established index and are thus passively managed.

Exchange-Traded Funds (ETFs) - If you prefer not to invest with mutual funds, ETFs can
be a viable alternative. You can basically think of ETFs as mutual funds that trade like
stocks. ETFs are similar to mutual funds in that they represent a large basket of stocks usually grouped by sector, capitalization, country and the like - except that they are not

actively managed, but instead track a chosen index or other basket of stocks. Because
they are passively managed, ETFs offer cost savings over mutual funds while providing
diversification. ETFs also cover a wide range of asset classes and can be a useful tool for
rounding out your portfolio.
Step 3: Reassessing Portfolio Weightings
Once you have an established portfolio, you need to analyze and rebalance it periodically
because market movements may cause your initial weightings to change. To assess your
portfolio's actual asset allocation, quantitatively categorize the investments and determine their
values' proportion to the whole.
The other factors that are likely to change over time are your current financial situation, future
needs and risk tolerance. If these things change, you may need to adjust your portfolio
accordingly. If your risk tolerance has dropped, you may need to reduce the amount of equities
held. Or perhaps you're now ready to take on greater risk and your asset allocation requires that a
small proportion of your assets be held in riskier small-cap stocks.
Essentially, to rebalance, you need to determine which of your positions are overweighted and
underweighted. For example, say you are holding 30% of your current assets in small-cap
equities, while your asset allocation suggests you should only have 15% of your assets in that
class. Rebalancing involves determining how much of this position you need to reduce and
allocate to other classes.
Step 4: Rebalancing Strategically
Once you have determined which securities you need to reduce and by how much, decide which
underweighted securities you will buy with the proceeds from selling the overweighted
securities. To choose your securities, use the approaches discussed in Step 2.
When selling assets to rebalance your portfolio, take a moment to consider the tax implications
of readjusting your portfolio. Perhaps your investment in growth stocks has appreciated strongly
over the past year, but if you were to sell all of your equity positions to rebalance your portfolio,
you may incur significant capital gains taxes. In this case, it might be more beneficial to simply
not contribute any new funds to that asset class in the future while continuing to contribute to
other asset classes. This will reduce your growth stocks' weighting in your portfolio over time
without incurring capital gains taxes.
At the same time, always consider the outlook of your securities. If you suspect that those same
overweighted growth stocks are ominously ready to fall, you may want to sell in spite of the tax
implications. Analyst opinions and research reports can be useful tools to help gauge the outlook
for your holdings. And tax-loss selling is a strategy you can apply to reduce tax implications.
Remember the Importance of Diversification.
Throughout the entire portfolio construction process, it is vital that you remember to maintain
your diversification above all else. It is not enough simply to own securities from each asset
class; you must also diversify within each class. Ensure that your holdings within a given asset
class are spread across an array of subclasses and industry sectors.

As we mentioned, investors can achieve excellent diversification by using mutual funds and
ETFs. These investment vehicles allow individual investors to obtain the economies of scale that
large fund managers enjoy, which the average person would not be able to produce with a small
amount of money.
The Bottom Line
Overall, a well-diversified portfolio is your best bet for consistent long-term growth of your
investments. It protects your assets from the risks of large declines and structural changes in the
economy over time. Monitor the diversification of your portfolio, making adjustments when
necessary, and you will greatly increase your chances of long-term financial success.

Efficient Frontier

DEFINITION of 'Efficient Frontier'

A set of optimal portfolios that offers the highest expected return for a defined level of risk or the
lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are
sub-optimal, because they do not provide enough return for the level of risk. Portfolios that
cluster to the right of the efficient frontier are also sub-optimal, because they have a higher level
of risk for the defined rate of return.

INVESTOPEDIA EXPLAINS 'Efficient Frontier'

Since the efficient frontier is curved, rather than linear, a key finding of the concept was the
benefit of diversification. Optimal portfolios that comprise the efficient frontier tend to have a
higher degree of diversification than the sub-optimal ones, which are typically less diversified.
The efficient frontier concept was introduced by Harry Markowitz in 1952 and is a cornerstone
of modern portfolio

fficient-market hypothesis
From Wikipedia, the free encyclopedia

The Efficient-market hypothesis(EMH) states that it is impossible to "beat the market" because
stock market efficiency causes existing share prices to always incorporate and reflect all relevant
information. According to the EMH, stocks always trade at their fair value on stock exchanges,
making it impossible for investors to either purchase undervalued stocks or sell stocks for
inflated prices. As such, it should be impossible to outperform the overall market through expert
stock selection or market timing, and that the only way an investor can possibly obtain higher
returns is by purchasing riskier investments.[1]

The following are the main assumptions for a market to be efficient:

A large number of investors analyze and value securities for profit.

New information comes to the market independent from other news and in a
random fashion.

Stock prices adjust quickly to new information.

Stock prices should reflect all available information.

Financial theories are subjective. In other words, there are no proven laws in finance, but rather
ideas that try to explain how the market works [2]
There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". The weak
form of the EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already
reflect all past publicly available information. The semi-strong form of the EMH claims both that
prices reflect all publicly available information and that prices instantly change to reflect new
public information. The strong form of the EMH additionally claims that prices instantly reflect
even hidden or "insider" information. Critics have blamed the belief in rational markets for much
of the late-2000s financial crisis.[3][4][5] In response, proponents of the hypothesis have stated that
market efficiency does not mean having no uncertainty about the future, that market efficiency is
a simplification of the world which may not always hold true, and that the market is practically
efficient for investment purposes for most individuals.[6]